It’s not enough for financial advisors to help protect their clients from market losses. They must also defend against hidden tax risks that can erode investment gains.
Among these risks, the wash-sale rule stands out as a significant hurdle, silently threatening the effectiveness of tax-loss harvesting strategies. Fortunately, advancements in financial technology are reshaping how advisors manage this challenge at a more detailed level, even allowing for the detection of wash sales within a family of accounts and within separately managed accounts.
This ultimately allows for more precise, efficient and compliant portfolio management.
The Hidden Risk of Wash Sales
Tax-loss harvesting is an essential tool in minimizing taxes on investment portfolios, but this process has been complicated by the wash-sale rule. The rule, enforced by the Internal Revenue Service, disallows capital losses if the same or a “substantially identical” security is repurchased within 30 days before or after the sale.
If a wash sale occurs, the disallowed loss is deferred, added to the cost basis of the repurchased security, and cannot be used to offset taxable gains in the current year.
For financial advisors, this creates a daunting challenge. In managing large portfolios, especially those with assets spread across multiple accounts — such as individual retirement accounts, brokerage accounts and trusts — tracking every sale and purchase to avoid triggering a wash sale is a complicated, error-prone task. Historically, advisors relied on manual tracking or basic tools to detect wash-sale violations, a labor-intensive process.
Missing a wash sale can not only result in lost tax benefits but also expose advisors and clients to compliance risks.
The Role of Automation in Preventing Wash Sales
The advent of automation has transformed tax efficiency, making it easier for advisors to navigate the complexities of the wash-sale rule.
For example, certain rebalancing and tax-optimization tools are able to automate the detection of wash-sale violations. Unlike traditional account-by-account monitoring methods, such solutions take a more comprehensive approach, monitoring wash-sale triggers across all accounts within a household in real time.
This capability is crucial because clients often spread their assets across investment vehicles, making it impractical to manage portfolios on an account-by-account basis. By continuously scanning for potential wash-sale violations, the right technology can enable advisors to take preemptive action, preventing disallowed losses and maintaining compliance with IRS regulations.
This holistic, automated approach not only safeguards clients’ tax benefits but also helps advisors avoid manually tracking every transaction.
